3 - Economic Efficiency

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Gustavo Indart

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ECONOMIC EFFICIENCY Maximum Net Social Benefit: P = MC Implies the output where the benefit to society of an additional unit of output equals the cost to society of an additional unit of output. Pareto Efficient Allocation (Pareto Optimality): P = MC The allocation of resources where no person is worse off from trading and any additional trade will make some person worse off Efficiency Loss (Welfare or Deadweight Loss) Measure efficiency loss of an output Qo by the difference between Price and Marginal Cost between the output Qo and optimal output at P = MC. It is the difference between Demand and Marginal Cost between given output and optimal output. This is equivalent to the net loss of consumers’ surplus and producers’ surplus at the output relative to optimal output Competition => Optimum Allocation (Allocation Efficiency, 0 Efficiency Loss) Competitive market equilibrium implies that P = MC, which implies that competitive markets give the optimal allocation of resources Monopoly Regulation Monopolies create efficiency loss by reducing output below competitive output and increasing price above competitive price. Governments attempt to eliminate the efficiency loss caused by a monopoly using two methods: 1) Marginal Cost Pricing (for ‘normal’ monopolies) MC pricing results in 0 efficiency loss but still leaves the monopoly with an economic profit. 2) Average Cost Pricing (for natural monopolies) MC pricing is unattainable for a natural monopoly because there is an economic loss at the output where P = MC. AC pricing is the regulatory option in this case since the output where price equals average cost is the maximum output that would not entail economic loss for the monopoly. The monopoly makes 0 economic profit and there is efficiency loss at this output. Externalities Costs of a commodity other than the costs of the firms producing the commodity or benefits of a commodity other than the benefits of the households purchasing the commodity The concept of allocative efficiency refers to the optimal allocation of resources for society, so the marginal benefits and marginal costs of market Demand and Supply encompass only part of the social benefits and costs of a community. The existence of externalities means that competitive market equilibrium does not give the optimal allocation of resources. 1) Cost (or Negative) Externalities Optimal allocation occurs where P = MC Socialt P* and Q*, not where price equals only MC Market Competitive equilibrium results in efficiency loss since the cost of output beyond optimal social allocation is greater than society’s willingness to pay. The problem with externalities is that they are not internal
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